How to Calculate Cap Rate for Rental Properties

Cap rate = the most important metric for comparing rental properties. Understand cap rate, calculate it correctly, use it to make smarter investment decisions. Here's everything you need to know.

What is Cap Rate?

Capitalization Rate (Cap Rate): The rate of return on a property based on income it generates, regardless of financing.
Simple definition: Annual income ÷ Purchase price = Cap Rate
Why it matters: Instantly compare properties across different prices

Calculate Cap Rate Automatically

The Cap Rate Formula

Cap Rate = (NOI / Property Value) × 100

NOI = Net Operating Income (Annual)

→ Rental Income - Operating Expenses

→ Does NOT include mortgage payment

Property Value = Purchase price or current market value

Higher cap rate = better return (generally). But context matters!

Step-by-Step Cap Rate Calculation

Step 1: Calculate Gross Rental Income

Total potential rent for one year:

• Monthly rent × 12 months
• Include all units if multi-family
• Don't include other income yet

Example: $2,000/month × 12 = $24,000 annual gross income

Step 2: Subtract Vacancy Loss

Account for periods without tenants:

• Typical vacancy rate: 5-10%
• Gross Income × (1 - Vacancy Rate)

Example: $24,000 × (1 - 0.07) = $22,320 effective income

Step 3: Calculate Operating Expenses

Annual costs to operate the property:

• Property taxes
• Insurance
• Property management fees
• Maintenance and repairs
• HOA fees (if applicable)
• Utilities (if owner-paid)
• DO NOT include mortgage payment
• DO NOT include depreciation

Example: $3k + $1.2k + $2k + $2k + $800 = $9,000 annual OpEx

Step 4: Calculate NOI

NOI = Effective Income - Operating Expenses

This is your property's income potential before financing

Example: $22,320 - $9,000 = $13,320 NOI

Step 5: Apply Cap Rate Formula

Cap Rate = (NOI / Property Price) × 100

Divide annual NOI by purchase price, multiply by 100 for percentage

Example: ($13,320 / $200,000) × 100 = 6.66% Cap Rate

Complete Cap Rate Example

$200,000 Rental Property

Income Calculation

Monthly Rent: $2,000
Annual Gross: $2,000 × 12 = $24,000
Vacancy (7%): -$1,680
Effective Income: $22,320

Operating Expenses

Property Taxes: $3,000
Insurance: $1,200
Property Management: $2,000
Maintenance: $2,000
HOA: $800
Total OpEx: $9,000

NOI Calculation

Effective Income: $22,320
- Operating Expenses: -$9,000
Net Operating Income: $13,320

Cap Rate Result

$13,320 NOI ÷ $200,000 Price × 100

= 6.66% Cap Rate

What is a Good Cap Rate?

Cap Rate Ranges by Market Type

High Growth Markets (4-6% Cap)

Major metros, strong appreciation, lower cash flow

Examples: San Francisco, Seattle, Austin

Balanced Markets (6-8% Cap)

Mid-sized cities, moderate growth, decent cash flow

Examples: Charlotte, Indianapolis, Tampa

Cash Flow Markets (8-12% Cap)

Smaller markets, limited appreciation, high cash flow

Examples: Memphis, Cleveland, Birmingham

Remember: Higher cap rate ≠ automatically better. Consider appreciation, market stability, tenant quality.

Cap Rate vs. Cash-on-Cash Return

Cap Rate

• Ignores financing
• Based on property value
• Compares different properties
• Used by all-cash buyers
• Industry standard metric

Formula: NOI / Property Value

Cash-on-Cash

• Includes mortgage payment
• Based on cash invested
• Measures your actual return
• Used by financed buyers
• More relevant for investors

Formula: Cash Flow / Cash Invested

Common Cap Rate Mistakes

❌ Including Mortgage in Calculation

Cap rate is financing-independent. Never subtract mortgage payment from NOI.

❌ Using First Year NOI Only

NOI should be stabilized/normalized. Account for below-market rents, expected increases.

❌ Forgetting Vacancy in NOI

Always reduce gross income by vacancy rate before calculating NOI.

❌ Comparing Different Property Types

Don't compare SFR cap rates to commercial. Each property type has different typical cap rates.

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